Wall Street's Worst-Kept Secret

If you own stocks, you should own small caps. OK, that's not really personal investment advice. It's Wall Street's worst-kept secret: Over the long haul, small-company stocks make you more money.

You're serious about this
You want an edge. So why make this difficult? History tells us that investors who make the most money over the long term buy and hold common stocks.

At least, they have since Ibbotson Associates started keeping track back in 1926 (and yes, I think it's still true). Investors looking to goose their returns even more own small caps, also according to Ibbotson.

The way I see it, we have a few choices. We can take a chance on a low-cost small-cap fund. We can buy a small-cap exchange-traded fund (ETF) -- I own a few myself. Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Well, sort of. You see, I have the occasional cup of joe with my friend Tom Gardner, co-founder of The Motley Fool -- a guy who made a career out of beating Wall Street to profits on small, well-run companies.

And you know what? I can admit that Tom and the team of analysts he hand-picked to manage his Motley Fool Hidden Gems newsletter service are building a portfolio of small caps I couldn't have found on my own. What's their secret?

I think it's that they focus more on value, while I tend to get wowed by story. For all of that, we do look for many of the same things in a great small company:

  • Solid management with significant stakes.
  • Great, sustainable businesses.
  • Dominant positions in niche markets.
  • Sterling balance sheets.
  • Strong free cash flow.

As hard as it is to imagine now, these traits led investors to John Morgridge and Cisco Systems (Nasdaq: CSCO  ) back in the day; even Jim Sinegal and Costco (Nasdaq: COST  ) . I don't have to tell you how those investments worked out.

Good work if you can get it
I know what you're thinking: Who wouldn't want to own stocks like those -- at least in their prime? And you're right. That's why it's so hard to beat the pros with familiar stocks like those now; if they're really all that, they're going to cost you.

But what are you going to do instead? Take a chance on some fly by-night outfit? Also a good point. But notice I said familiar stocks – not necessarily familiar companies. There's a subtle difference if you think about it.

To see what I mean, consider big retailers Target (NYSE: TGT  ) and Lowe's (NYSE: LOW  ) . They're both heavily owned by institutional investors now, but that wasn't always the case. I remember a time when both had strong regional and even national bricks-and-mortar footprints long before they were closely followed on Wall Street.

Need more proof?
Check out Fool Tim Hanson's list of the best-performing stocks of the past 10 years. You won't find a bunch of "widely helds" like Dell (Nasdaq: DELL  ) or Microsoft (Nasdaq: MSFT  ) on the list. Though don't be surprised if you recognize a company like juice drink-maker Hansen Natural (Nasdaq: HANS  ) from "real life" -- just as you probably recognized Target and Lowe's from the strip mall. 

Of course, that's your edge: You can find established, profitable companies with unknown stocks. Some you've heard of; some you may not have. Peter Lynch was a master at digging up these undiscovered gems. That's a big part of why he earned his Fidelity Magellan fundholders an average of nearly 30% a year.

Some more personal advice
If you agree that what I say makes sense, test the waters with a low-cost small-cap index fund like iShares S&P 600 Small-Cap Value Index (IJS), and then shift gradually into the stocks Tom Gardner's guys tell you about each month in his Motley Fool Hidden Gems newsletter.

Even better, check out the small-cap stocks the team is buying right now for its own real-money portfolio. At last count, these picks were outperforming the market by 2-to-1. Best of all, you can try the complete Hidden Gems service free.

You can even print out every back issue, if you like. And there's never any pressure to subscribe. I haven't seen a market better suited to small caps since 2003. I bought then, and I'm buying more now. I hope you'll consider doing likewise. To learn more about trying Hidden Gems for free, simply click here.

This article was originally published Jan. 7, 2005. It has been updated.

Paul Elliott owns shares of the iShares S&P Small-Cap 600 Growth Index and the iShares S&P Small-Cap 600 Value Index. is a Motley Fool Stock Advisor pick. Dell and Microsoft are Inside Value choices. Hansen Natural is a Rule Breakers selection. You can see the entire Hidden Gems scorecard with your free trial. The Motley Fool has a full disclosure policy.

Read/Post Comments (0) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1002177, ~/Articles/ArticleHandler.aspx, 10/23/2016 6:36:25 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 1 day ago Sponsored by:
DOW 18,145.71 -16.64 -0.09%
S&P 500 2,141.16 -0.18 -0.01%
NASD 5,257.40 15.57 0.30%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/21/2016 4:00 PM
COST $148.97 Down -1.07 -0.71%
Costco Wholesale CAPS Rating: ****
CSCO $30.15 Down -0.01 -0.03%
Cisco Systems CAPS Rating: ****
DELL.DL $0.00 Down +0.00 +0.00%
Dell CAPS Rating: *
LOW $70.65 Up +0.76 +1.09%
Lowe's CAPS Rating: ****
MNST $147.26 Up +0.65 +0.44%
Monster Beverage CAPS Rating: ***
MSFT $59.66 Up +2.41 +4.21%
Microsoft CAPS Rating: ****
TGT $68.23 Up +0.52 +0.77%
Target CAPS Rating: ***